How to Make Money in this Environment
by Serguei Chervachidze, CBRE Capital Markets
The financial crisis of 2007-2009 has made a major dent in CRE asset values. As the economy starts a slow recovery, these values are now beginning to stabilize, although some adjustment is still due. A recovery in values is expected eventually to follow this stabilization. Commercial real estate investors are naturally asking how one makes money in such a market. Do you buy now, or sell? Do you structure your strategy around appreciation returns by snapping up cheap CRE assets, or do you instead rely on a steady income stream?
The answers to these questions lie in the expected behavior of asset values (which drive appreciation returns) and income streams (i.e. income returns). Both elements’ behavior is captured well by the capitalization rate. Graph 1 below shows the history and CBRE-EA forecast of cap rates for the four sectors of commercial real estate, utilizing data from the National Council of Real Estate Investment Fiduciaries (NCREIF).
NCREIF Capitalization Rates Baseline Scenario Sources: NCREIF, CBRE Econometric Advisors Investment Outlook: Spring 2010.
Our forecast for the cap rates calls for 55- to 70-basis point (bps) cap rate increases (from the current levels of 6.74% for office, 7.25% industrial, 6.73% retail, and 5.60% for multifamily; NCREIF cap rates are reflective of prime market assets and are generally significantly lower than average market caps; furthermore, with a strong appraisal lag in NCREIF data, NCREIF indices adjust more slowly to market conditions) from 2009Q4 to mid-2011 across property types, with cap rates then slowly decreasing to 2005-6 levels by 2012. This expected increase is the amount by which capitalization rates will grow beyond the upward adjustment that has manifested to date (2009Q4). The overall increases from the trough levels of cap rates in late 2007 are significantly higher.
What do these expected increases imply for future investment performance? They mean that asset values still have to finish their downward correction, bottoming out sometime toward the end of this year or next year. CBRE Econometric Advisors forecasts peak-to-trough drops of 30-40%, depending on property type (see CBRE-EA Investment Outlook: Spring 2010 for details).
With the drop in values (the denominator in cap rates) larger than the drop in income (the numerator), income will be relatively stable on average. Unlike in the recent past, where most returns were driven by asset value growth (appreciation returns), over the next two years returns will be driven by strong income yields. Graphs 2 and 3 below demonstrate this point by contrasting the performance of NCREIF portfolios in the heady days of the asset bubble with the CBRE-EA forecast of investment performance for the next five years.
Historical NCREIF Returns: The Heady Days Sources: NCREIF, CBRE Econometric Advisors Investment Outlook: Spring 2010.
NCREIF Returns Forecast (Baseline): 5-yr Average Sources: NCREIF, CBRE Econometric Advisors Investment Outlook: Spring 2010.
There is, however, a possibility of much stronger investment performance. If investors wait out the remaining decline in values and buy at the cap rate peak (forecasted for 2011), they will enjoy the benefits of both decent income returns and property value appreciation. Investments made at the cap rate peak will see healthy 5-year average returns. Graph 4 demonstrates this point.
NCREIF Returns Forecast (Baseline): 5-yr Average from Cap Rate Peak Sources: NCREIF, CBRE Econometric Advisors Investment Outlook: Spring 2010>.
The bottom line then, is that the type of returns investors will enjoy will differ over time. In the next two years, values will finally have finished their downward adjustment and will be poised for growth. During this period, the last phase of adjustment in asset values will depress 5-year average appreciation returns, with the only significantly positive returns coming in the form of income yields. Once the adjustment is over, investors will be able to reap healthy appreciation and income returns when they buy at the cap rate peak.
